Explainer: Hong Kong's currency finds strength in testing times

HONG KONG (Reuters) - The Hong Kong dollar is bumping against the top end of its narrow 7.75-7.85 band against the U.S. dollar and is among the best-performing currencies this year even as the city’s economy struggles to contain the fallout of the coronavirus.

FILE PHOTO: A Hong Kong dollar note is seen in this illustration photo May 31, 2017. REUTERS/Thomas White/Illustration

The Hong Kong Monetary Authority (HKMA) spent HK$7.7 billion (799.5 million pounds) last week to defend the peg as the currency rose to its upper limit for the first time in more than four years.

Traders often borrow in currencies with lower interest rates to fund purchases in higher-yielding markets, such as Hong Kong currently, creating inflows and strengthening a currency.

As part of the peg arrangement, Hong Kong’s official “base rate” follows U.S. Federal Reserve policy. But once the Fed’s main rate loses its 50 basis points lead over the 5-day average of borrowing costs between Hong Kong’s banks - as it did in March - the HKMA’s policy tracks the local interbank rate.

The Fed Funds Target Rate is at 0-0.25% and Hong Kong’s base rate was 1.19% on Monday, indicating a rich yield cushion for the Hong Kong dollar.

Rates at which Hong Kong banks lend to each other are leading their U.S. equivalents by the most since 1999. They are also more prone to spikes with less cash around. Interbank cash levels, measured by the aggregate balance, are down 84% from a 2015 peak of HK$426 billion.

HOW ARE STOCK MARKET FLOWS SUPPORTING THE HKD?

Hong Kong’s stock market is one of Asia’s largest.

Initial public offerings, such as the heavily subscribed recent listing of Akeso, have locked up cash and kept interest rates elevated, said Carie Li, economist at OCBC Wing Hang Bank.

Chinese investors have poured cash into Hong Kong shares, many of which trade cheaper than peers on the mainland and “Southbound” net purchases through the Stock Connect link reached a record $17.93 billion in March.

WHY WOULD HKD STAY STRONG WHILE ITS ECONOMY WEAKENS?

The Hong Kong government is spending record sums to prop up the economy, battered by months-long protests in 2019, and in partial lockdown now to fight the coronavirus.

It could finance some of this spending with deposits it holds with the HKMA. With limited HKD to hand, the central bank may meet this demand by selling foreign currency assets, said Chi Lo, senior economist at BNP Paribas Asset Management.